Optimum Currency Areas and the European Experience

1
Optimum Currency Areas and the European Experience

• A short history of the EU, EMS and EMU
• Theory of optimal currency areas
• Is the EU an optimal currency area?
• Other considerations of an economic and monetary
  union

2
What Is the European Union (EU)?

• Treaty of Rome in 1957 established the EU as a
  customs union
• The EU is a system of international institutions,
  which now represents 25 European countries
  through the
• European Parliament elected by citizens of
  member countries. It passes European laws.
• Council of the European Union is the EU's main
  decision-making body. Its meetings are attended
  by one minister from each of the EUs national
  governments. It coordinates policies and
  concludes international agreements between the EU
  and other countries/organizations.
• European Commission executive body. It drafts
  proposals for new European laws, which it
  presents to the European Parliament and the
  Council. It is responsible for implementing the
  decisions of Parliament and the Council it
  implementing its policies, running its programs
  and spending its funds
• Court of Justice interprets EU law

3
Membership of the EU

• To be a member of the EU, a country must, among
  other things,
• have low barriers that limit trade and flows of
  financial capital
• adopt common rules for emigration and immigration
  to ease the movement of people.
• establish common workplace safety and consumer
  protection rules
• establish certain political and legal
  institutions that are consistent with the EUs
  definition of liberal democracy.

4
Members of the European Union
EEA European Economic Association, a free trade
group with the EU.
5
Why the EU?

• Countries that established the EU had several
  goals
• To enhance Europes power in international
  affairs as a union of countries, the EU could
  represent more economic and political power in
  the world.
• To make Europe a unified market a large market
  with free trade, free flows of financial capital
  and free migration of peoplein addition to fixed
  exchange rates or a common currencywere believed
  to foster economic growth and economic well
  being.
• To make Europe politically stable and peaceful.

6
The European Monetary System from 19791998

• From 19791993, the EMS defined the exchange
  rate mechanism to allow most currencies to
  fluctuate /- 2.25 around target exchange rates
  (relative to the German DM)
• The exchange rate mechanism allowed larger
  fluctuations (/- 6) for currencies of Portugal,
  Spain, Britain (until 1992) and Italy (until
  1990)
• These countries wanted greater flexibility with
  monetary policy.
• The wider bands were also intended to prevent
  speculation caused by differing monetary and
  fiscal policies.

7
The EMS from 19791998 (cont.)

• To prevent speculation,
• early in the EMS some exchange controls were also
  enforced to limit trading of currencies.
• But from 19871990 these controls were lifted in
  order to make the EU a common market for
  financial capital.
• a credit system was also developed among EMS
  members to lend to countries that needed assets
  and currencies that were in high demand in the
  foreign exchange markets.

8
The EMS from 19791998 (cont.)

• But because of differences in inflation rates and
  in fiscal policies across the EMS, speculative
  attacks started to take place.
• As a result, Britain and Italy left the EMS in
  September 1992. Britain allowed the pound to
  float against other European currencies.
• As a result, exchange rate mechanism was
  redefined in 1993 to allow for bands of /-15 of
  the target value in order devalue many currencies
  relative to the DM

9
Italian Lira/German DM exchange rate
10
The EMS from 19791998 (cont.)

• But eventually, each EMS member adopted similarly
  restrained fiscal and monetary policies, and the
  inflation rates in the EMS eventually converged
• In effect, EMS members were following the
  restrained monetary policies of Germany, which
  has traditionally had low inflation.

11
Inflation Convergence
12
Policies of the EU and EMS

• Single European Act of 1986 recommended that many
  barriers to trade, financial capital flows and
  immigration be removed by December 1992.
• Maastricht Treaty, proposed in 1991, required
  three stages to transform the EMS into a economic
  and monetary union and convergence criteria
• Stage one liberalization of the movement of
  capital. It began on 1 January 1990
• Stage two began on 1 January 1994 and provides
  for convergence of the Member States' economic
  policies
• Stage three the creation of a single currency
  and the establishment of a European Central Bank
  (ECB) by January 1, 1999 and a system of European
  banks

13
Policies of the EU and EMS (cont.)

• Convergence criteria
• attain exchange rate stability defined by the ERM
  before adopting the euro
• attain price stability a maximum inflation rate
  of 1.5 above the average of the three lowest
  national inflation rates among EU members.
• Fiscal limits
• Public sector deficits no higher than 3 of GDP
  (except if real GDP growth rate is below -2 or
  below -0.75 with the concurrence of the
  Council).
• Government debt below 60 of GDP

14
Policies of the EU and EMS (cont.)

• Participation criteria
• Fiscal limits (as before)
• The Stability and Growth Pact, negotiated in
  1997, allows for early warning system, Excessive
  Deficit Procedure (EDP) and financial penalties
  on countries with excessive deficits or debt

15
The Economic and Monetary Union (EMU)

• The euro was adopted on January 1, 1999 by
  irrevocably fixing the conversion rates
• 11 countries joined Greece joined on January 1,
  2001
• The previous exchange rate mechanism became
  obsolete.
• But a new exchange rate mechanismERM 2was
  established between the economic and monetary
  union and outside countries.
• It allowed countries (either within or outside of
  the EU) that wanted to enter the economic and
  monetary union in the future to maintain stable
  exchange rates before doing so.
• It allowed EU members outside of the economic and
  monetary union to maintain fixed exchange rates
  if desired
• January 1, 2002 national currencies were
  replaced by the Euro

16
Why the EMU?

• EU members adopted the euro for principally 4
  reasons
• Unified market the belief that greater market
  integration and economic growth would occur.
• Political stability the belief that a common
  currency would make political interests more
  uniform.
• The belief that German influence under the EMS
  would be moderated under a European System of
  Central Banks.
• Eliminate the possibility of devaluations/revaluat
  ions with free flows of financial capital,
  capital flight and speculation could occur in an
  EMS with separate currencies, but would be more
  difficult with a single currency.

17
EU/EMS Members of the Economic and Monetary Union
(EMU)
Countries in red EU members that use the euro
and are members of the EMU. Countries in blue EU
members that do not use the euro and are
not members of the EMU.
18
Recent developments in the EMU inflation
19
Monetary policy
20
Real GDP growth
21
Government deficits
22
Excessive Deficit Procedure

• Procedure applied to EMU members that violate the
  deficit limit of 3
• Deadline of four months for effective corrective
  action to be taken. This action should ensure
  completion of the correction of the excessive
  deficit in the year following its identification
• If the Member State fails to comply, the Council
  normally decides to impose sanctions, at the
  latest, ten months after reporting of the data
  indicating an excessive deficit exists
• Sanctions take the form of a non-interest-bearing
  deposit with the Commission. The fixed component
  equal to 0.2 of GDP and a variable component
  linked to the size of the deficit. Additional
  deposits in the following years may be requested
  not exceed the upper limit of 0.5 of GDP.
• A deposit is as a rule converted into a fine if,
  in the view of the Council, the excessive deficit
  has not been corrected after two years.

23
Troubles in Paradise.

• EDP for
• Portugal in 2002
• Germany in 2002
• France in 2003
• Greece in 2004
• Netherlands in 2004
• Italy in 2005
• In November 2003, the ECOFIN Council decided not
  to act upon the Commissions recommendation to
  start a EDPs for France and Germany. The Court of
  Justice later annulled the ECOFIN Council
  decision

24
The Reform of the SGP

• In March 2005 the SGP was reformed
• Changes in the preventive arm
• Country-specific medium-term objectives
• Speed of adjustment to the medium-term objectives
• Changes in the corrective arm
• New definition of severe economic downturn
• Inclusion of other relevant factors
• Extension of deadline for correction of excessive
  deficit

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Theory of Optimum Currency Areas

• The theory of optimum currency areas (Mundell
  1961) argues that the optimal area for a common
  currency is one that is highly economically
  integrated.
• economic integration means free flows of
• goods and services (trade)
• financial capital and physical capital
• workers/labor (immigration and emigration)

26
Theory of Optimum Currency Areas (cont.)

• Single currency has costs and benefits
• Benefits
• avoid the uncertainty of exchange rate
  fluctuations
• avoid international transaction costs
• Define this gain that would occur if a country
  joined a common currency area as the monetary
  efficiency gain
• In general, the higher the degree of economic
  integration, the greater the monetary efficiency
  gain.

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Theory of Optimum Currency Areasthe GG schedule

monetary efficiency gains
GG
degree of economic integration
28
Theory of Optimum Currency Areas (cont.)

• Economic integration also allows prices to
  converge between members of a fixed exchange rate
  system and a potential member.
• The law of one price is expected to hold better
  when markets are integrated.

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Theory of Optimum Currency Areas (cont.)

• Costs
• loss of monetary policy independence for
  stabilizing output and employment
• the loss of automatic adjustment of exchange
  rates to changes in aggregate demand.
• Define this loss that would occur if a country
  joined a fixed exchange rate system as the
  economic stability loss
• In general, the higher the degree of economic
  integration, the lower the economic stability
  loss.

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Theory of Optimum Currency Areasthe LL schedule

economic stability loss
LL
degree of economic integration
31
Theory of Optimum Currency Areas (cont.)

• At some critical point measuring the degree of
  integration, the monetary efficiency gain will
  exceed the economic stability loss for a member
  considering joining a fixed exchange rate system.

32
Theory of Optimum Currency Areas (cont.)

gains and losses
GG
LL
q1
degree of economic integration
33
Theory of Optimum Currency Areas (cont.)

• A reduction in the size and frequency of
  country-specific shocks
• This is an inward-shift of the LL curve
• This reduces the critical level of economic
  integration

34
A reduction in size and frequency of
country-specific shocks

gains and losses
GG
LL
LL
q1
q2
degree of economic integration
35
Is the EU an Optimum Currency Area?

• For large EU members, intra-EU trade averages 10
  to 20 of GDP
• For small EU members, intra-EU trade is higher,
  about 20 to 50 of GDP
• This compares with trade of less than 2 of EU
  GDP to the US
• But trade between regions in the US is a larger
  fraction of regional GDP
• So, intra-EU trade is large overwhelmingly
  large?

36
Is the EU an Optimum Currency Area? (cont.)
37
Is the EU an Optimum Currency Area? (cont.)

• Deviations from the law of one price also occur
  in many EU markets.
• If EU markets were greatly integrated, then the
  (currency adjusted) prices of goods and services
  should be nearly the same across markets.
• The price of the same BMW car varies 29.5
  between British and Dutch markets.
• How much does price discrimination occur?

38
Is the EU an Optimum Currency Area? (cont.)

• There is also no evidence that regional migration
  is extensive in the EU
• Very little labor mobility
• Europe has many languages and cultures, which
  hinder migration and labor mobility
• Unions and regulations also impede labor
  movements between industries and countries.

39
Is the EU an Optimum Currency Area? (cont.)

40
Is the EU an Optimum Currency Area? (cont.)

• There is evidence that financial capital flows
  more freely in the EU after 1992 and 1999.
• But capital mobility without labor mobility can
  make the economic stability loss greater.

41
Is the EU an Optimum Currency Area? (cont.)
Capital mobility implies Labor immobility implies
42
Is the EU an Optimum Currency Area? (cont.)

• Suppose negative technological shock in France
  AF falls
• Both RF and WF fall
• Since capital is mobile, capital leaves France
  for Germany so that RF RG
• But a lower KF means that wages are lower in
  France!

43
Is the EU an Optimum Currency Area? (cont.)

• Are idiosyncratic shocks likely in the EU?
• Econometric estimates of demand and supply shocks
  in the EU shows that
• Shocks are more correlated with Germany for
  Northern countries (Belgium, Netherlands,
  France) less correlated for Southern and Nordic

44
Correlation of shocks in the EU
45
Fiscal Federalism

• Fiscal payments between countries in the EMUs
  federal system, or fiscal federalism, may help
  offset the economic stability loss from joining
  an economic and monetary union.
• It is minimal in the EMU
• It is very important in the US a 1 fall in a
  states income generates a 25c offset as lower
  taxes and higher transfers from the Federal
  government

46
Do Currency Unions Create Trade?

• On average, two countries that are members of the
  same currency union are likely to trade three
  times as much with each other as countries that
  do not share a currency
• Problem with this empirical estimate it is based
  on very small countries
• How does this prediction carry over to the EMU?